Welcome to paradise!

Alasdair Macleod – 3 July 2009
In all the financial panic and worry about economic prospects, few will have noticed that we are about to enter the paradise beloved by socialists and communists alike: the public sector is becoming larger than the private sector in both the US and the UK for the first time ever.

This year in the US on a forecast GDP of $14,240bn, the sum of federal and state spending is expected to be $7,418bn, or 48% of the total. The only reason this proportion is expected to peak at that level is the optimistic assumptions produced by the Congressional Budget Office. Likewise, in the UK for fiscal 2009/10, total managed expenditure plus public sector depreciation plus PFI spending comes to just under £700bn, which is also about 48% of the forecast GDP for this year. Again, this percentage is expected to fall as the economy recovers next year.

Realistically, the recession in these two nations will be deeper and longer than official forecasts state, so it is certain that both US and UK private sectors will continue to contract relative to government spending, and it is therefore inevitable that these ratios will exceed 50% for both economies next year. Furthermore, no allowance is ever made in GDP estimates for the costs imposed on the private sector by government for the collection and administrations of taxes, nor is any allowance made for the compliance costs of conforming to myriad laws and regulations, mostly unnecessary. The US and UK are no longer mixed economies, but socialist paradises.

The private sector is firmly under the jack-boot of the state.

This relationship between the public and private sectors arrived at the point of no return with the onset of this slump. The Keynesian policy of deficit spending in a downturn has to be based on the ability of the private sector to recover and fund government expenditure over the economic cycle. With the private sector becoming the smaller of the two, this assumption is becoming arithmetically impossible. The situation is plainly beyond either government’s control, as their own finances are spiralling out of control. Public sector commitments are escalating considerably faster than official sources ever expected, and the life-blood of tax receipts are also collapsing.

A timid debate about public expenditure has developed in the UK, but the newly-elected President Obama is still busy imposing extra costs in the form of sustainable energy policies and healthcare reform. No politician is willing to be cast as Mr Nasty, so proposed solutions will be half-hearted mixtures of tax increases and “cost-savings”, which usually combine into the worst possible outcome. Tax rises will depress the private sector further, and not produce the expected revenue. Cost-savings are meant to be achieved by reducing waste, but the result is always a reduction in services to those that need them while bureaucracy lives on. We have experienced this in previous down-turns, which have all been relatively mild. But this time there is no obvious escape: the Hydra’s breath of the public sector is overwhelming, and there is no Heracles to slay it.

The hopelessness of the situation is reflected in the opinions of some independent commentators. Marc Faber of The Gloom Boom Doom Report in a Bloomberg interview this week said he now believes we have seen the bottom in the S&P 500 Index, not because prospects have improved, but because he now believes the outlook is hyper-inflationary, driving cash towards equities rather than bonds. He also believes that the further crises he expects will be met with more waves of fiat money.

Whether or not he is right about the S&P 500 Index only time will tell, but his analysis otherwise confirms what we already know. Governments have overtly turned to inflation as a means of taxation: this is the real definition of quantitative easing, and we should not be fooled by the technical phraseology. In truth, central banks exist only to inflate the currency, and anyone who doubts this should answer this question: when did you last see a central bank actually withdraw narrow money from circulation? Central banks may make money more expensive to slow its growth, but they never actually withdraw it.

But currencies are also inflated covertly. It turns out that the Fed is understating M1, the narrowest definition of money, by some $740bn, or by 30% of the actual total. This error arises from the treatment of retail cash deposits held at the banks, which are misclassified as “savers’ deposits” rather than “checkable”. The benefit for the banks is that this reduces the statutory reserves they have to deposit at the Fed, but it does lead to under-reporting of narrow money. The Fed is aware of this, but makes no correction for it, and this is the explanation for why the monetary base, which should be a component of M1, is now larger than the whole.

So Faber is right about the outlook for inflation, since there is no political mandate to face economic reality, and there is no discipline from a semi-detached gold standard, as there was in the 1930s.

As the economy turns down when the current inventory-led bounce fades, the politicians will be faced with the first proper wave of industrial bankruptcies. It is already very difficult for industry, which is being squeezed by banks anxious to reduce overall loan exposure, and by customers who are taking longer to pay. Suppliers are also abandoning business relationships at the slightest whiff of payment risk and are demanding payment up-front. Evidence is shown in the absence of jobs and persistent redundancies. The effect is that only a small downturn will be enough to make bankruptcies soar. The conclusion is that the tipping point for manufacturing and commercial services is still ahead of us.

One shudders to think how much more quantitative easing will be engineered to bail out businesses, because to fail to support business will bring on a second banking crisis. The banks are alive to these risks and their piggy-in-the-middle role, which is why they are backing out of commercial lending. The contraction of GDP in the private sector has a long way to go, and the public sector faces escalating rescue costs, higher welfare commitments and collapsing tax receipts. The public sector will continue to grow relative to the private sector far beyond 2010.

Some paradise!

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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